Archive for the ‘Compensation’ category

There has been much talk about how unacceptable the degree of financial inequality that there is in the US. And it seems to be getting worse and worse.

But what we have seems to be exactly what most people want in general. Probably the only part of it that most people would change is the part where they personally are not one of the fortunate wealthy few.

The lottery is the perfect example of a mechanism to achieve an unequal society.

Everyone buys a ticket for a small amount of money. The jackpot grows until it reaches $301 million. The winner is drawn. The result is one rich person with $301M and everyone else goes back to their regular life and stops dreaming about becoming that one rich person – for a week at least.

If that happens several times a year and everyone is either a winner or has a low to moderate job, then a vastly unequal society develops.

After one year, there will be 3 – 4 multi-millionaires and the entire rest of the population will have wealth that is a tiny fraction of those ultra rich. After a decade, the ranks of the ultra rich will have grown to 30 or 40. At that point, the top .000001% of the population will have .03% of the total wealth.

Each year, the country will grow more and more unequal, with a tiny fraction of the population commanding an ever growing proportion of the total wealth.

But that is why there is no uprising against the super rich. Everyone else believes that they might one day hit the lottery and win their position in that group. And when that happens, they do not want a tax regime, for instance, that will just take their riches away.

Like this:

We give much too little consideration to potential for conflict of interest in risk reporting.

Take for instance weather risk reporting.

"Sneeuwschuiver". Licensed under CC BY-SA 2.5 via Wikimedia Commons

Many of the people who report on Weather Risk have a financial interest in bad weather. Not that they own snow plowing services or something. But take TV stations for example. Local TV station revenue is largely proportional to their number of viewers. Local news and weather are often the sole part of their schedule that they produce themselves and therefore get all or almost all of the revenue. And viewership for local news programs may double with an impending snowstorm. So they have a financial interest in predicting more snow. The Weather Channel has the same dynamic, but a wider area from which to draw to find extreme weather situations. But if there is any hint of a possible extreme weather situation in a major metropolitan area with millions of possible viewers, they have a strong incentive to report the worst case possibility.

This past January, there were some terrible snow forecasts for New York and Philadelphia:

For the Big Apple, the great Blizzard of 2015 was forecast to rival the paralyzing 1888 storm, dubbed the White Hurricane. Up to three feet of snow was predicted. Reality: About 10 inches fell.

The forecast in Philadelphia wasn’t any better – and arguably worse. Up to 14 inches of snow were forecast. The City of Brotherly Love tallied roughly 2 inches, about the same as Washington, D.C.

In other cases, we go to the experts to get information about possible disasters from diseases. But their funding depends very much on how important their specialty is seen to be to the politicians who approve their funding.

In 2005, the Bird Flu was the scare topic of the year.

“I’m not, at the moment, at liberty to give you a prediction on numbers, but I just want to stress, that, let’s say, the range of deaths could be anything from 5 to 150 million.”

David Nabarro, Senior United Nations system coordinator for avian and human influenza

Needless to say, the funding for health systems can be strongly impacted by the fear of such a pandemic. At them time that statement was made, worldwide Bird Flu deaths were slightly over 100. Not 100 thousand, 100 – the number right after 99.

But the purpose of this post is not writing this to disparage weather reporters or epidemiologists. It is to caution risk managers.

Sometimes risk managers get the idea that they are better off if everyone had more concern for risk. They take on the roll of Dr. Doom, pointing out the worst case potential in every situation.

This course of action is usually not successful. Instead of building respect for risk, the result is more often to create a steady distrust of statements from the risk manager. The Chicken Little effect results.

Instead, the risk manager needs to focus on being painstakingly realistic in reporting about risk. Risk is about the future, so it is impossible to get it right all of the time. That is not the goal. The goal should be to make reports on risk that consistently use all of the information available at the time the report is made.

And finally, a suggestion on communicating risk. That is that risk managers need to develop a consistent language to talk about the likelihood and severity of a risk. RISKVIEWS suggests that risk managers use three levels of likelihood:

Normal Volatility (as in within). Each risk should have a range of favorable and unfavorable outcomes within the range of normal volatility. This could mean within one standard deviation, or with a 1 in 10 likelihood. So normal volatility for the road that you drive to work might be for there to be one accident per month.

Realistic Disaster Scenario. This might be the worst situation for the risk that has happened in recent memory, or it might be a believable bad scenario that hasn’t happened for risks where recent experience has been fairly benign. For that road, two accidents in a week might be a realistic disaster. It actually happened 5 years ago. For the similar road that your spouse takes to work, there haven’t been any two accident weeks, but the volume of traffic is similar, so the realistic disaster scenario for that road is also two accidents in a week.

Worst case scenario. This is usually not a particularly realistic scenario. It does not mean worst case, like the sun blowing up and the end of the solar system. It does mean something significantly worse than what you expect can happen. For the risk of car accidents on your morning commute, the worst case might be a month with 8 accidents.

So the 150 million number above for flu deaths is a worst case scenario. As were the Great Blizzard predictions. What actually happened was in line with normal volatility for a winter storm in those two cities.

If you, the risk manager, learn to always use language like the above, first of all, it will slow you down and make you think about what you are saying. Eventually, your audience will get to learn what your terminology means and will be able to form their own opinion about your reliability.

And you will find that credibility for your risk reporting has very favorable impact on your longevity and compensation as a risk manager.

There is no single approach to risk management that will work for all risks nor, for any one risk, is there any one approach to risk management that will work for all times. Rational adaptability is the strategy of altering … Continue reading →

In 1973, CS Holling, a biologist, argued that the “Equilibrium” idea of natural systems that was then popular with ecologists was wrong.He said that natural systems went through drastic, unpredictable changes – such systems were “profoundly affected by random events”. … Continue reading →

Many theoreticians and more than a few executives take the position that incentive compensation is a powerful motivator. It therefore follows that careful crafting of the incentive compensation program is all that it takes to get the most out of a … Continue reading →

As video gaming has become more and more sophisticated, and as the hardware to support those games has become capable of playing movies and other media, video game consoles have now become “Entertainment Systems”. Continue reading →

Insurance company risk managers need to recognize that traditional activities like underwriting, pricing and reserving are vitally important parts of managing the risks of their firm. Enterprise risk management (ERM) tends to focus upon only two or three of the … Continue reading →

In just a few days, actuaries will be the first group of Enterprise Risk Management (ERM) professionals to make a commitment to specific ERM standards for their work. In 2012, the Actuarial Standards Board passed two new Actuarial Standards of … Continue reading →

WillisWire has on several occasions featured opinions from a large number of our contributors about what might be the next emerging risk in various sectors. But what can be done once you have identified an emerging risk? Continue reading →

Slowly, but surely, and without a lot of fanfare, U.S. insurance regulators have been orchestrating a sea change in their interaction with companies over solvency. Not as dramatic as Solvency II in Europe, but the U.S. changes are actually happening … Continue reading →

ZURICH—In another move to rein in compensation, UBS AG notified employees it will claw back part of the bonuses due to its best-paid investment bankers, according to a person familiar with the matter.

The action by Switzerland’s largest lender by assets is likely to further upset some top employees at a bank that already has faced problems retaining top talent and is now in the midst of a revamp of its investment bank. The UBS board has decided to take back 50% of share-based bonuses awarded last year to investment bankers whose bonuses exceeded two million Swiss francs.

Wall Street Journal, 9 February, 2012

A claw back of bonuses. This totally changes the risk reward for employees.

Banker pay is shrinking. See Forget the big bonuses; a pay squeeze is coming. Tett puts banker pay into a very long term historical perspective. It seems that banker pay was previously so high – and is it a coincidence that was right before the Depression.

The reason why banker pay matters so much is that finance does not follow the same economic laws of supply and demand as physical goods. Many people talk as if they do, but there is at least one major difference that was clearly evidenced in the run up to the financial crisis. Scarcity does not apply to financial goods. So there is no natural limiting feedback loop. Remember what happened with CDOs related to mortgages? When demand went up, price didn’t. Supply leaped instead. Synthetic CDOs filled the need and there is an unlimited supply of synthetic financial assets.

The amount of financial goods compared to the rest of the economy is therefore totally flexible. Think about it for a minute. The world cannot be any more wealthy because there are more financial goods. The sole result of the expansion of financial goods is to tilt the ownership of the wealth of the world away from the real economy and towards the banks and others in finance.

Limiting banker pay limits the incentive to inflate the financial system. Clawbacks means that when the bankers and others in finance do manage to push those financial goods up anyway, any excess compensation that results can be recovered when the excess of financial goods reverses itself.

How should ideas like these impact on ERM systems? Is it at all reasonable to say that they should not? Definitely not.

These potential shocks illustrate the need for the ERM system to be reflexive. The system needs to react to changes in the risk environment. That would mean that it needs to reflect differences in the risk environment in three possible ways:

In the calibration of the risk model. Model assumptions can be adjusted to reflect the potential near term impact of the shocks. Some of the shocks are certain and could be thought to impact on expected economic activity (Japanese disaster) but have a range of possible consequences (changing volatility). Other shocks, which are much less certain (end of QE2 – because there could still be a QE3) may be difficult to work into model assumptions.

With Stress and Scenario Tests – each of these shocks as well as combinations of the shocks could be stress or scenario tests. Riskviews suggest that developing a handful of fully developed scenarios with 3 or more of these shocks in each would be the modst useful.

In the choices of Risk Appetite. The information and stress.scenario tests should lead to a serious reexamination of risk appetite. There are several reasonable reactions – to simply reduce risk appetite in total, to selectively reduce risk appetite, to increase efforts to diversify risks, or to plan to aggressively take on more risk as some risks are found to have much higher reward.

The last strategy mentioned above (aggressively take on more risk) might not be thought of by most to be a risk management strategy. But think of it this way, the strategy could be stated as an increase in the minimum target reward for risk. Since things are expected to be riskier, the firm decides that it must get paid more for risk taking, staying away from lower paid risks. This actually makes quite a bit MORE sense than taking the same risks, expecting the same reward for risks and just taking less risk, which might be the most common strategy selected.

The final consideration is compensation. How should the firm be paying people for their performance in a riskier environment? How should the increase in market risk premium be treated?

Global ERM Webinars – January 12 – 14 (CPD credits)

We are pleased to announce the fourth global webinars on risk management. The programs are a mix of backward and forward looking subjects as our actuarial colleagues across the globe seek to develop the science and understanding of the factors that are likely to influence our business and professional environment in the future. The programs in each of the three regions are a mix of technical and qualitative dissertations dealing with subjects as diverse as regulatory reform, strategic and operational risks, on one hand, and the modeling on tail risks and implied volatility surfaces, on the other. For the first time, and in keeping with our desire to ensure a global exchange of information, each of the regional programs will have presentations from speakers from the other two regions on subjects that have particular relevance to their markets.

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Steering.

If you ask most actuaries who are involved in ERM, they would tell you that Risk Steering IS Enterprise Risk Management.

Standard & Poor’s calls this Strategic Risk Management:

SRM is the Standard & Poor’s term for the part of ERM that focuses on both the risks and returns of the entire firm. Although other aspects of ERM mainly focus on limiting downside, SRM is the process that will produce the upside, which is where the real value added of ERM lies. The insurer who is practicing SRM will use their risk insights and take a portfolio management approach to strategic decision making based on analysis that applies the same measure for each of their risks and merges that with their chosen measure of income or value. The insurer will look at the possible combinations of risks that it can take and the earnings that it can achieve from the different combinations of risks taken, reinsured, offset, and retained. They will undertake to optimize their risk-reward result from a very quantitative approach.

For life insurers, that will mean making strategic trade-offs between products with credit, interest rate, equity and insurance risks based on a long-term view of risk-adjusted returns of their products, choosing which to write, how much to retain and which to offset. They will set limits that will form the boundaries for their day-to-day decision-making. These limits will allow them to adjust the exact amount of these risks based on short-term fluctuations in the insurance and financial markets.

For non-life insurers, SRM involves making strategic trade-offs between insurance, credit (on reinsurance ceded) and all aspects of investment risk based on a long-term view of risk-adjusted return for all of their choices. Non-life SRM practitioners recognize the significance of investment risk to their total risk profile, the degree or lack of correlation between investment and insurance risks, and the fact that they have choices between using their capacity to increase insurance retention or to take investment risks.

Risk Steering is very similar to Risk Trading, but at the Total Firm level. At that macro level, management will leverage the risk and reward information that comes from the ERM systems to optimize the risk reward mix of the entire portfolio of insurance and investment risks that they hold. Proposals to grow or shrink parts of the business and choices to offset or transfer different major portions of the total risk positions can be viewed in terms of risk adjusted return. This can be done as part of a capital budgeting / strategic resource allocation exercize and can be incorporated into regular decision making. Some firms bring this approach into consideration only for major ad hoc decisions on acquisitions or divestitures and some use it all of the time.

There are several common activities that may support the macro level risk exploitation:

Economic Capital. Realistic risk capital for the actual risks of the company is calculated for all risks and adjustments are made for the imperfect correlation of the risks. Identification of the highest concentration of risk as well as the risks with lower correlation to those higher concentration risks is the risk information that can be exploited. Insurers will find that they have a competitive advantage in adding risks to those areas with lower correlation to their largest risks. Insurers should be careful to charge something above their “average” risk margin for risks that are highly correlated to their largest risks. In fact, at the macro level as with the micro level, much of the exploitation results from moving away from averages to specific values for sub classes.

Capital Budgeting. The capital needed to fulfill proposed business plans is projected based on the economic capital associated with the plans. Acceptance of strategic plans includes consideration of these capital needs and the returns associated with the capital that will be used. Risk exploitation as described above is one of the ways to optimize the use of capital over the planning period.

Risk Adjusted Performance Measurement (RAPM). Financial results of business plans are measured on a risk-adjusted basis. This includes recognition of the economic capital that is necessary to support each business as well as the risk premiums and loss reserves for multi-period risks such as credit losses or casualty coverages.

Risk Adjusted Compensation. An incentive system that is tied to the risk exploitation principles is usually needed to focus attention away from other non-risk adjusted performance targets such as sales or profits. In some cases, the strategic choice with the best risk adjusted value might have lower expected profits with lower volatility. That will be opposed strongly by managers with purely profit related incentives. Those with purely sales based incentives might find that it is much easier to sell the products with the worst risk adjusted returns. A risk adjusted compensation situation creates the incentives to sell the products with the best risk adjusted returns.

A fully operational risk steering program will position a firm in a broad sense similarly to an auto insurance provider with respect to competitors. There, the history of the business for the past 10 years has been an arms race to create finer and finer pricing/underwriting classes. As an example, think of the underwriting/pricing class of drivers with brown eyes. In a commodity situation where everyone uses brown eyes to define the same pricing/underwriting class, the claims cost will be seen by all to be the same at $200. However, if the Izquierdo Insurance Company notices that the claims costs for left-handed, brown-eyed drivers are 25% lower than for left handed drivers, and then they can divide the pricing/underwriting into two groups. They can charge a lower rate for that class and a higher rate for the right handed drivers. Their competitors will generally lose all of their left handed customers to Izquierdo, and keep the right handed customers. Izquierdo will had a group of insureds with adequate rates, while their competitors might end up with inadequate rates because they expected some of the left-handed people in their group and got few. Their average claims costs go up and their rates may be inadequate. So Izquierdo has exploited their knowledge of risk to bifurcate the class, get good business and put their competitors in a tough spot.

Risk Steering can be seen as a process for finding and choosing the businesses with the better risk adjusted returns to emphasize in firm strategic plans. Their competitors will find that their path of least resistance will be the businesses with lower returns or higher risks.

JP Morgan in the current environment is showing the extreme advantage of macro risk exploitation. In the subprime driven severe market situation, JP Morgan has experienced lower losses than other institutions and in fact has emerged so strong on a relative basis that they have been able to purchase several other major financial institutions when their value was severely distressed. And by the way, JP Morgan was the firm that first popularized VaR in the early 1990’s, leading the way to the development of modern ERM. However, very few banks have taken this approach. Most banks have chosen to keep their risk information and risk management local within their risk silos.

This is very much an emerging field for non-financial firms and may prove to be of lower value to them because of the very real possibility that risk and capital is not the almost sole constraint on their operations that it is within financial firms as discussed above.